All That Glitters Is No longer Gold: Startup Valuations And The Liquidation Preference Overhang


Let's starting up with how VCs fund startups. Thousands digital ink has been spilled on VC funding, so we'll limit ourselves to the aspects germane to the liquidation overhang. A VC investor will be issued most fashionable inventory, now no longer overall inventory, which is what founders and workers gain (the felony responsibility usually by the spend of alternate ideas). Most in sort inventory simply manner that its holders devour certain rights above and beyond those of holders of overall inventory. Amongst those rights is the liquidation desire, which is almost as vital as the cost (or valuation) at which a VC invests. The liquidation desire offers the VC a priority in being paid within the occasion of a liquidation. For these functions, liquidation entails now no longer most productive the inappropriate stuff (eg, financial disaster), but it furthermore entails any occasion whereby shareholders rating proceeds for their fairness, comparable to a merger, acquisition, or sale of substantially all the corporate's assets. The will permits the holder to gain paid sooner than the holders of the overall inventory; meaning, if an organization were sold, the VC investor receives proceeds from the sale sooner than overall stockholders.

The market normal for liquidation desire is a 1x extra than one, which manner that the VC investor receives 100% of its funding support in a liquidity occasion sooner than holders of overall inventory (ie, workers) can gain any proceeds from that occasion. If a VC has invested $ 10 million dollars with a 1x liquidation desire, it’ll rating the first $ 10 million dollars due to this of a liquidity occasion.

When a liquidation occasion happens, the VC investigators devour the possibility of taking the liquidation desire or converting their most fashionable shares to overall shares and participating within the distribution as overall stockholders. Naturally, they’re going to impact whichever ends in extra cash.

To be dazzling, there is a solid argument for why VCs may per chance well also peaceable gain a liquidation desire. They soak up a form of possibility by pouring in millions of bucks into an early-stage company and legitimately wish to offer protection to that funding. The liquidation desire genuinely offers the VC downside security to gain its funding support (so much of the assorted owners are “sweat” fairness, whereas it's the VCs who are writing the mammoth exams the corporate wants to grow).


That is the attach the “overhang” piece is available in. Effectively, the liquidation desire overhang comes into play the attach the valuation of the corporate is lower than the launch air money that has been invested by VCs. Let's spend an example to crystallize the level. You've worked for an organization for 5 years (meaning you've achieve on your time and all your alternate ideas devour vested) and it's true been launched that the corporate will be sold for $ 50 million. Let's convey that you and the assorted workers devour 10% of the corporate, the founders devour 10%, and the VCs devour invested $ forty million for an eighty% stake.

With a 1x liquidation desire, the VCs would gain their $ forty million support, and the founders and workers would clutch part within the perfect $ 10 million. On this scenario, the founders would gain $ 5 million and the workers would rating $ 5 million. However do no longer forget that the VCs devour the possibility to snatch their liquidation desire or convert their most fashionable shares into overall shares and clutch part within the proceeds from the liquidation as overall stockholders. On this example, the VC would genuinely be indeterminate (assuming that the holders of most fashionable inventory impact now no longer rating any dividends) between taking the liquidation desire or converting to overall (eighty% of $ 50 million is $ forty million).

Now let's convey the corporate is going to be sold for $ forty million. The VCs would clutch their liquidation desire, which manner that they gain their $ forty million funding support, leaving the founders and workers with nothing. On this example, the VCs would pretty clutch their liquidation desire than convert to overall because within the occasion that they remodeled, they may per chance perchance gain most productive $ 32 million ($ forty million * .eight).


The brutally correct answer to this quiz is now no longer great. Workers collectively impact now no longer wield ample energy to lead choices touching on to how great VC funding to snatch on and what break that funding may per chance well also peaceable clutch. And we gain it – it's rather the provoking proposition to snatch a haircut in salary to work for a startup, gain paid closely in illiquid company inventory, and if you lastly gain to that exit, there's a possibility that your fairness is price nothing, although the corporate is sold for so much of millions of bucks.

The simplest component an employee can impact is to head in eyes wide launch – attempt to gain primarily the most info sooner than taking the job. Moreover to the “trim” questions to inquire right via compensation negotiations, which we beforehand covered in these pages, a possible employee can furthermore inquire his suitor how great VC capital has been invested within the corporate (CrunchBase or AngelList may per chance well also furthermore devour this info, but that it’s possible you’ll per chance gain extra legit info straight from the corporate). The questions we devour instantaneous asking within the past will support you approximate valuation. Whenever you know the blueprint great VC money has been achieve into the corporate, that it’s possible you’ll per chance originate an educated opinion regarding the specter of an overhang scenario.

There may per chance be a silver lining right here. The mark of making a tech company has reach down over time. This implies that less launch air funding is required than within the past, which in turn lowers the probability for an overhang bother.


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